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IRS changes rules on lump sum window programs

The Internal Revenue Service (IRS) has surprisingly issued a notice of its intention to amend the required minimum distribution (RMD) regulations under the Internal Revenue Code (Code) to limit the use of lump sum payments to replace annuity payments being paid by tax-qualified defined benefit plans—an increasingly common practice for employers trying to manage risk and cost. In Notice 2015-49, the IRS states that these plans will no longer be permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution. The change is proposed to apply as of July 9, 2015, with certain limited exceptions for arrangements already in existence as of July 9, 2015.

In an effort to manage costs and eliminate the long-term risks inherent in defined benefit plans, a number of employers in recent years (including Ford and General Motors) have amended their plans to provide a limited period—a window—during which retirees currently receiving annuity payments may elect to convert the payments into a lump sum that is payable immediately. These arrangements are sometimes referred to as “lump sum risk-transferring programs” because the longevity and investment risk is transferred from the plan to the retirees. The new regulations will essentially end such arrangements and could significantly affect long-term planning for plan sponsors.

Legal Background

Code Section 401(a)(9) provides that tax-qualified plans must make RMDs. Generally, these rules require that an employee must begin receiving payments by the “required beginning date,” which is April 1 of the calendar year following the later of (1) the calendar year in which the employee attains age 70½ or (2) the calendar year in which the employee retires. The ability to delay distribution until the calendar year in which an employee retires does not apply in the case of a 5-percent owner. The regulations provide that, absent an applicable exception, distributions of an employee’s entire interest must be paid in the form of periodic annuity payments over certain specified periods.

Rationale for the Change

According to the Notice, the RMD rules were “crafted to provide an administrable way to ensure that a distribution of the employee’s benefit will not be unduly tax-deferred.” As a corollary, the IRS states in the Notice that, “[i]f a participant has the ability to accelerate distributions at any time, then the actuarial cost associated with that acceleration right would result in smaller initial benefits, which contravenes the purpose of § 401(a)(9).” Citing an exception in the regulations that had been used by plans as a basis for providing the lump sums, the IRS believes that the exception is limited only to cases where ongoing annuity payments are increased and does not apply to an acceleration of annuity payments.

Exception for Existing Arrangements

The Notice indicates that the new regulations will not apply to an acceleration with respect to certain arrangements already in existence prior to July 9, 2015. These apply to a plan amendment specifically providing for the implementation of a lump sum risk-transferring program:

adopted (or specifically authorized by a board, committee, or similar body with authority to amend the plan) prior to July 9, 2015;

with respect to which a private letter ruling or determination letter was issued by the IRS prior to July 9, 2015;

with respect to which a written communication to affected plan participants stating an explicit and definite intent to implement the lump sum risk-transferring program was received by those participants prior to July 9, 2015; or

adopted pursuant to an agreement between the plan sponsor and an employee representative (with which the plan sponsor has entered into a collective bargaining agreement) specifically authorizing implementation of such a program that was entered into and was binding prior to July 9, 2015.

These new rules may severely limit proposals being considered by employers to reduce the longevity and investment risk in their defined benefit plans. Employers may have to narrow the scope of their window programs such as to include only participants who are not in pay status (deferred vested participants). Employers that have the resources and ability to do so may consider terminating their plans and purchasing group annuity contracts to transfer the risk.

Given the large employers like General Motors and Ford who have used this strategy, there may well be a backlash against the IRS regulations. However, for the time being, employers with these programs need to carefully evaluate how they will proceed.

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